Role of shareholder loans?
What is the role of a shareholder loan in an LBO situation. I can only think of tax advantages but any other reasons why PE equity is structured as shareholder loan? How do you model a shareholder loan in an LBO? If a PE firm has a 100% equity and 50% of the shareholder loan how would you model returns?
The Affect of LBO capital structure on shareholders
from certified user @Relinquis"
in our real estate private equity deals we only use shareholder loans for tax purposes. we treat them as equity when modelling returns, although our tax guys model the actual structure so that we get the right number for the tax effects.
we usually have different off-shore companies that provide the debt, so others might have a different experience.
This chart is compares three hypthetically structured LBO's and the advantages and disadvantages to each. At the bottom of this post is a link to the full article. It goes describes how each LBO structure impacts shareholders, among other things.
in our real estate private equity deals we only use shareholder loans for tax purposes. we treat them as equity when modelling returns, although our tax guys model the actual structure so that we get the right number for the tax effects.
we usually have different off-shore companies that provide the debt, so others might have a different experience.
Recommended Reading
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| divide_and_conquer.pdf 126.28 KB | 126.28 KB |
in our real estate private equity deals we only use shareholder loans for tax purposes. we treat them as equity when modelling returns, although our tax guys model the actual structure so that we get the right number for the tax effects.
we usually have different off-shore companies that provide the debt, so others might have a different experience.
great read: http://www.kirkland.com/siteFiles/kirkexp/publications/2411/Document1/D…
in general, law firm's publications are a great source of in depth info
thanks Oreos
shareholder loan vs. preferred equity (Originally Posted: 01/26/2016)
Hi,
I'm trying to understand what the difference is between a shareholder loan and preferred equity? Can I have both when structuring an LBO? Are the interests paid on either of them, tax deductible (assuming the preferred equity pays PIK)?
Thanks
Max
bump
I am assuming you're referring to a seller note when you say shareholder loan. Seller notes can come in many forms, even as preferreds. Most of the time I see them structured as an unsecured note with some a cash/toggle feature, but again they can come in all flavors. A preferred is typically not viewed as debt IF it lacks debt-like features such as mandatory put rights or maturity date. Preferreds typically accrue interest or dividend and the full face plus accrual are paid upon a monetization event (sale, equity offering, divy recap). An LBO can certainly have both. Many PE firms actually structure their cash equity as a preferred strip with option to convert to common. All interest is tax deductible although I don't think the accrued dividend value of a preferred is.
You can have whatever securities you want in an LBO, why wouldn't you be able to....
Shareholder loan and preferred equity is the same...
There are typically three equity "tranches" of equity in an LBO: - PECs (preferred equity certificates) accruing at a certain PIK - Common equity - Sweet equity (Management will get a certain percentage of the common "for free")
PECS/Common are simply used to structure the management package and is not a typical loan (no interest/tax deductability).
The sponsor will typically have all (almost all) of the PEC's and common will be held by both the sponsor and management. If total IRR is higher than the PEC PIK rate, then the IRR on the common equity will be higher than for the PEC.
For example: TEV: 100 Debt: 40 Equity: 60 O/w: PEC: 50 (held by sponsor at 10% PIK) Common: 10 (5 held by sponsor and 5 by management) Sweet equity of 10%
Let's say they exit in one year at 1.2x MOIC, i.e. 1 year gross IRR of 20%.
Total Equity Proceeds: 72 PECs: 55 Total Common Proceeds: 17 Of which 10% Sweet: 1.7 Residual Common: 15.3
Proceeds to sponsor: PECs: 55 Common: 7.65 Total: 62.65
Returns to Sponsor: PECs: 10% IRR Common: 53% IRR Total Net MOIC: 1.14x Total Net IRR: 13.9%
Proceeds to management: Common: 7.65 Sweet: 1.7 Total: 9.35 Total Net MOIC: 1.87x Total Net IRR: 87%
If the sponsor does well, management should do really well, and this is how it is typically structured. It will depend on how much the management can roll/invest and above was just an example, in reality Net MOIC/IRR would be higher given a 20% gross IRR (but again depends on the management package).
Conversely, the benefit of a PEC for the sponsor is visible when gross IRR is same/below PEC PIK rate.
In the case of exit at 1.1x MOIC all of the proceeds will go to the sponsor.
You basically described the differences in preferred equity, common equity and a MIP. If OP is referring to a seller note then it does not necessarily equate to a preferred equity strip.
Thanks for this. I have a question - if the majority of the sponsor's capital on entry is structured as preferred equity, are they not just limiting the vast majority of their returns to the given PIK interest rate (in your example, 10%)? They're only making the large returns (the 53% you calculated), on a relatively small proportion of their input capital.
Thanks!
Why would you interpret OPs question as a seller note? I was clarifying why you would use a shareholder loan/PEC assuming he thought they were different (which they are not).
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